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Economic Production Lot Size Model

Inventory Model with Planned Shortages

Quantity Discounts for the EOQ Model

2005 Thomson/South-Western

Inventory Models

with two basic questions:

How much should be ordered each time

When should the reordering occur

The objective is to minimize total variable

cost over a specified time period (assumed

to be annual in the following review).

2005 Thomson/South-Western

Inventory Costs

processing an order, regardless of the order

quantity

Holding cost -- usually a percentage of the value of

the item assessed for keeping an item in inventory

(including finance costs, insurance, security costs,

taxes, warehouse overhead, and other related

variable expenses)

Backorder cost -- costs associated with being out

of stock when an item is demanded (including lost

goodwill)

Purchase cost -- the actual price of the items

Other costs

2005 Thomson/South-Western

Deterministic Models

demand and the other parameters of the

problem to be deterministic and constant.

The deterministic models covered in this

chapter are:

Economic order quantity (EOQ)

Economic production lot size

EOQ with planned shortages

EOQ with quantity discounts

2005 Thomson/South-Western

inventory models is the economic order

quantity (EOQ).

The variable costs in this model are annual

holding cost and annual ordering cost.

For the EOQ, annual holding and ordering

costs are equal.

2005 Thomson/South-Western

Assumptions

Demand is constant throughout the year at

D items per year.

Ordering cost is $Co per order.

Holding cost is $Ch per item in inventory per

year.

Purchase cost per unit is constant (no

quantity discount).

Delivery time (lead time) is constant.

Planned shortages are not permitted.

2005 Thomson/South-Western

Formulas

Q*=

2DCo/Ch

D/ Q *

years

Q */D

(holding + ordering)

2005 Thomson/South-Western

Bart's Barometer Business is a retail outlet

that

deals exclusively with weather equipment.

Bart is trying to decide on an inventory

and reorder policy for home barometers.

Barometers cost Bart $50 each and

demand is about 500 per year distributed

fairly evenly throughout the year.

2005 Thomson/South-Western

Reordering costs are $80 per order and

holding

costs are figured at 20% of the cost of the

item. BBB is

open 300 days a year (6 days a week and

closed two

weeks in August). Lead time is 60 working

days.

2005 Thomson/South-Western

Total Costs

= (Holding Cost) +

(Ordering Cost)

TC

= [Ch(Q/2)] + [Co(D/Q)]

= [.2(50)(Q/2)] + [80(500/Q)]

= 5Q + (40,000/Q)

2005 Thomson/South-Western

10

Q * = 2DCo /Ch =

89.44 90

2(500)(80)/10 =

Lead time is m = 60 days and daily

demand is

d = 500/300 or 1.667.

Thus the reorder point r = (1.667)(60) =

100. Bart should reorder 90 barometers when

his inventory position reaches 100 (that is 10

on hand and one outstanding order).

2005 Thomson/South-Western

11

Number of reorder times per year = (500/90)

= 5.56 or once every (300/5.56) = 54

working days (about every 9 weeks).

TC = 5(90) + (40,000/90) = 450 + 444 =

$894.

2005 Thomson/South-Western

12

Well now use a spreadsheet to implement

the Economic Order Quantity model. Well

confirm

our earlier calculations for Barts problem and

perform some sensitivity analysis.

This spreadsheet can be modified to

accommodate

other inventory models presented in this

chapter.

2005 Thomson/South-Western

13

A

B

1 BART'S ECONOMIC ORDER QUANTITY

2

3

Annual Demand

500

4

Ordering Cost

$80.00

5

Annual Holding Rate %

20

6

Cost Per Unit

$50.00

7

Working Days Per Year

300

8

Lead Time (Days)

60

2005 Thomson/South-Western

14

A

10 Econ. Order Qnty.

11 Request. Order Qnty

12 % Change from EOQ

13

14 Annual Holding Cost

15 Annual Order. Cost

16 Tot. Ann. Cost (TAC)

17 % Over Minimum TAC

18

19 Max. Inventory Level

20 Avg. Inventory Level

21 Reorder Point

22

23 No. of Orders/Year

24 Cycle Time (Days)

B

C

=SQRT(2*B3*B4/(B5*B6/100))

=(C11/B10-1)*100

=B5/100*B6*B10/2

=B4*B3/B10

=B14+B15

=B5/100*B6*C11/2

=B4*B3/C11

=C14+C15

=(C16/B16-1)*100

=B10

=B10/2

=B3/B7*B8

=C11

=C11/2

=B3/B7*B8

=B3/B10

=B10/B3*B7

=B3/C11

=C11/B3*B7

2005 Thomson/South-Western

15

A

10 Econ. Order Qnty.

11 Request. Order Qnty.

12 % Change from EOQ

13

14 Annual Holding Cost

15 Annual Order. Cost

16 Tot. Ann. Cost (TAC)

17 % Over Minimum TAC

18

19 Max. Inventory Level

20 Avg. Inventory Level

21 Reorder Point

22

23 No. of Orders/Year

24 Cycle Time (Days)

2005 Thomson/South-Western

C

89.44

75.00

-16.15

$447.21

$447.21

$894.43

$375.00

$533.33

$908.33

1.55

89.44

44.72

100

75

37.5

100

5.59

53.67

6.67

45.00

16

A 16.15% negative deviation from the EOQ

resulted in only a 1.55% increase in the

Total Annual Cost.

Annual Holding Cost and Annual Ordering

Cost are no longer equal.

The Reorder Point is not affected, in this

model, by a change in the Order Quantity.

2005 Thomson/South-Western

17

variation of the basic EOQ model.

A replenishment order is not received in one

lump sum as it is in the basic EOQ model.

Inventory is replenished gradually as the order

is produced (which requires the production

rate to be greater than the demand rate).

This model's variable costs are annual holding

cost and annual set-up cost (equivalent to

ordering cost).

For the optimal lot size, annual holding and

set-up costs are equal.

2005 Thomson/South-Western

18

Assumptions

Demand occurs at a constant rate of D

items per year.

Production rate is P items per year (and P

> D ).

Set-up cost: $Co per run.

Holding cost: $Ch per item in inventory per

year.

Purchase cost per unit is constant (no

quantity discount).

Set-up time (lead time) is constant.

Planned shortages are not permitted.

2005 Thomson/South-Western

19

Formulas

Q*=

Time between set-ups (cycle time):

years

D/Q *

Q */D

[(1/2)(1-D/P )Q *Ch] +

[DCo/Q *]

(holding + ordering)

2005 Thomson/South-Western

20

Non-Slip Tile Company (NST) has been using

production runs of 100,000 tiles, 10 times per year

to meet the demand of 1,000,000 tiles

annually. The set-up cost is $5,000 per

run and holding cost is estimated at

10% of the manufacturing cost of $1

per tile. The production capacity of

the machine is 500,000 tiles per month. The

factory

is open 365 days per year.

2005 Thomson/South-Western

21

This is an economic production lot size

problem with

D = 1,000,000, P = 6,000,000, Ch = .10, Co

= 5,000

Costs)

TC

= .04167Q + 5,000,000,000/Q

2005 Thomson/South-Western

22

Q*=

1/6)]

2(1,000,000)(5,000) /[(.1)(1 -

346,410

D/Q * =

2.89

2005 Thomson/South-Western

23

How much is NST losing annually by using

their present production schedule?

Optimal TC = .04167(346,410) +

5,000,000,000/346,410

= $28,868

Current TC

= .04167(100,000) +

5,000,000,000/100,000

= $54,167

Difference = 54,167 - 28,868 = $25,299

2005 Thomson/South-Western

24

There are 2.89 cycles per year. Thus, each

cycle lasts (365/2.89) = 126.3 days. The time

to produce 346,410 per run =

(346,410/6,000,000)365 = 21.1 days. Thus,

the machine is idle for:

126.3 - 21.1 =

runs.

105.2

2005 Thomson/South-Western

days between

25

Maximum Inventory

Current Policy:

Maximum inventory = (1-D/P )Q *

= (1-1/6)100,000

83,333

Optimal Policy:

Maximum inventory = (1-1/6)346,410 =

288,675

Machine Utilization

Machine is producing D/P =

time.

2005 Thomson/South-Western

1/6

of the

26

replenishment order does not arrive at or

before the inventory position drops to zero.

Shortages occur until a predetermined

backorder quantity is reached, at which time

the replenishment order arrives.

The variable costs in this model are annual

holding, backorder, and ordering.

For the optimal order and backorder quantity

combination, the sum of the annual holding

and backordering costs equals the annual

ordering cost.

2005 Thomson/South-Western

27

Assumptions

Demand occurs at a constant rate of D

items/year.

Ordering cost: $Co per order.

Holding cost: $Ch per item in inventory per year.

year.

Purchase cost per unit is constant (no qnty.

discount).

Set-up time (lead time) is constant.

Planned shortages are permitted (backordered

demand units are withdrawn from a replenishment

order when it is delivered).

2005 Thomson/South-Western

28

Formulas

Optimal order quantity:

Q * = 2DCo/Ch

(Ch+Cb )/Cb

Maximum number of backorders:

S * = Q *(Ch/(Ch+Cb))

Time between orders (cycle time): Q */D years

Total annual cost:

[Ch(Q *-S *)2/2Q *] + [DCo/Q *] + [S *2Cb/2Q

*]

(holding + ordering + backordering)

2005 Thomson/South-Western

29

Hervis Rent-a-Car has a fleet of 2,500

Rockets

serving the Los Angeles area. All Rockets are

maintained at a central garage. On

the average, eight Rockets per

month require a new engine.

Engines cost $850 each. There

is also a $120 order cost

(independent of the number of

engines ordered).

2005 Thomson/South-Western

30

Hervis has an annual holding cost rate of

30% on

engines. It takes two weeks to obtain the

engines after

they are ordered. For each week a car is out of

service,

Hervis loses $40 profit.

2005 Thomson/South-Western

31

D = 8 x 12 = 96; Co = $120; Ch = .30(850) =

$255;

Cb = 40 x 52 = $2080

Q*=

=

2DCo/Ch

(Ch + Cb)/Cb

2(96)(120)/255 x

(255+2080)/2080

= 10.07 10

S * = Q *(Ch/(Ch+Cb))

= 10(255/(255+2080)) = 1.09 1

2005 Thomson/South-Western

32

Demand is 8 per month or 2 per week.

Since

lead time is 2 weeks, lead time demand is 4.

Thus, since the optimal policy is to order 10

to

arrive when there is one backorder, the order

should

be placed when there are 3 engines remaining

in

inventory.

2005 Thomson/South-Western

33

Question:

How many days after receiving an order does

Hervis run out of engines? How long is Hervis

without any engines per cycle?

2005 Thomson/South-Western

34

Stockout: When and How Long

Answer

Inventory exists for Cb/(Cb+Ch) = 2080/

(255+2080)

= .8908 of the order cycle. (Note, (Q *-S *)/Q * =

.8908

also, before Q * and S * are rounded.)

An order cycle is Q */D = .1049 years = 38.3

days.

Thus, Hervis runs out of engines .8908(38.3) =

34 days

after receiving an order.

Hervis is out of stock for approximately 38 2005 Thomson/South-Western

35

34 = 4

applicable where a supplier offers a lower

purchase cost when an item is ordered in

larger quantities.

This model's variable costs are annual holding,

ordering and purchase costs.

For the optimal order quantity, the annual

holding and ordering costs are not necessarily

equal.

2005 Thomson/South-Western

36

Assumptions

Demand occurs at a constant rate of D

items/year.

Ordering Cost is $Co per order.

Holding Cost is $Ch = $CiI per item in

inventory per year (note holding cost is

based on the cost of the item, Ci).

Purchase Cost is $C1 per item if the quantity

ordered is between 0 and x1, $C2 if the order

quantity is between x1 and x2 , etc.

Delivery time (lead time) is constant.

Planned shortages are not permitted.

2005 Thomson/South-Western

37

Formulas

determining Q * will be demonstrated

Number of orders per year: D/Q *

Time between orders (cycle time): Q */D

years

Total annual cost: [(1/2)Q *Ch] + [DCo/Q *] +

DC

(holding + ordering +

purchase)

2005 Thomson/South-Western

38

Nick's Camera Shop carries Zodiac instant

film. The film normally costs Nick $3.20

per roll, and he sells it for $5.25. Zodiac

film has a shelf life of 18 months.

Nick's average sales are 21 rolls per

week. His annual inventory holding

cost rate is 25% and it costs Nick $20 to place an

order

with Zodiac.

2005 Thomson/South-Western

39

If Zodiac offers a 7% discount on orders of

400

rolls or more, a 10% discount for 900 rolls or

more,

and a 15% discount for 2000 rolls or more,

determine

Nick's optimal order quantity.

-------------------D = 21(52) = 1092; Ch = .25(Ci); Co = 20

2005 Thomson/South-Western

40

For C4 = .85(3.20) = $2.72

To receive a 15% discount Nick must order

at least 2,000 rolls. Unfortunately, the film's shelf

life is 18 months. The demand in 18 months (78

weeks) is 78 X 21 = 1638 rolls of film.

If he ordered 2,000 rolls he would have to

scrap 372 of them. This would cost more than the

15% discount would save.

2005 Thomson/South-Western

41

For C3 = .90(3.20) = $2.88

Q3* = 2DCo/Ch =

2(1092)(20)/[.25(2.88)] =

246.31

(not feasible)

The most economical, feasible quantity for C3 is 900.

Q2* = 2DCo/Ch = 2(1092)(20)/[.25(2.976)] =

242.30

(not feasible)

The most economical, feasible quantity for C2 is 400.

2005 Thomson/South-Western

42

For C1 = 1.00(3.20) = $3.20

Q1* = 2DCo/Ch = 2(1092)(20)/.25(3.20) =

233.67

(feasible)

When we reach a computed Q that is

feasible we stop computing Q's. (In this problem

we have no more to compute anyway.)

2005 Thomson/South-Western

43

Compute the total cost for the most economical, feasible

order quantity in each price category for which a Q *

was computed.

TC3 = (1/2)(900)(.72) +((1092)(20)/900)+(1092)(2.88) =

3493

TC2 = (1/2)(400)(.744)+((1092)(20)/400)+(1092)(2.976) =

3453

TC1 = (1/2)(234)(.80) +((1092)(20)/234)+(1092)(3.20) =

3681

Comparing the total costs for 234, 400 and 900, the

lowest total annual cost is $3453. Nick should order 400

rolls at a time.

2005 Thomson/South-Western

44

2005 Thomson/South-Western

45

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